14 ways of looking at risk

By Morningstar |  01-09-20 | 

Josh Charlson, director, manager selection, for Morningstar Research Services, conveys some of the nuances around risk, as well as to offer a framework for how investors can think about the various forms of risk in light of their own portfolios and plans.

1) Volatility

Volatility is one of the most commonly cited definitions of risk. It's usually depicted by the statistical concept of standard deviation, which essentially measures the range of fluctuation of an investment's returns. As a proxy for risk, volatility has the advantage of being easy to calculate and straightforward to understand and compare. But it also has limitations. One is that it makes no distinction between upside and downside volatility. Perhaps more significant is the question of how relevant volatility truly is to an investor. As Howard Marks of Oaktree Capital has written, "I don't think most investors fear volatility … What they fear is the possibility of permanent loss" (Marks' emphasis). This is not to say that volatility is without utility. It serves well as a first-blush measure of a security or fund's risk, and it can be usefully coordinated with an investor's risk tolerance: If an investor finds that he or she is prone to selling an investment in periods of heightened volatility, then a temporary fluctuation may indeed turn into permanently locked-in losses.

2) Risk-adjusted return

Risk-adjusted return measures are a step up from standard deviation, or simply ranking investments based on their return history. Commonly used measures include Sharpe ratio, information ratio, Jensen's alpha, and the Morningstar Rating for funds (colloquially, the "star rating"). Investment professionals often prefer risk-adjusted return measures because they show whether returns have been high enough to compensate for the risk. The Sharpe ratio, for example, calculates a fund's excess return over the risk-free rate relative to its standard deviation. One weakness of all these measures is that they are backward-looking, so you need to be cautious in applying them to future results.

3) Downside risk

Another way to think about risk is an investment's propensity to lose money (as suggested in the Marks quotation), since investors tend to be less concerned about volatility that works in their favor on the upside, and more about potential losses (loss aversion being a prominent behavioral bias). Measures that capture this include downside-capture ratio, bear-market performance, and Morningstar Risk (a component of the star rating). The Sortino ratio, while a risk-adjusted measure akin to the Sharpe ratio, specifically uses downside deviation in the denominator of its formula. A more sophisticated downside metric is value at risk, or VaR, which uses probabilistic methods. It's typically used by firms to estimate maximum potential losses at portfolio or firmwide levels, but despite its quantitative bona fides, the model came under heavy criticism for its failures during the 2008 financial crisis.

4) Non-normal risk

One weakness of traditional risk measures is that they assume normal return distributions, which won't account for investments with non-normal return patterns (such as some alternative investments) or outlier events (so-called "black swans"). Indeed, one criticism of VaR models in 2008 was that they failed to account for the degree of losses in the mortgage market that eventually occurred. Measures such as skew and kurtosis provide an indication of an investment's likelihood of producing results outside the normal distribution of returns, or what is sometimes called "fat-tail risk." But forecasting the chance of rare events is a tough enterprise. As Morningstar Canada's director of research Paul Kaplan has noted, market crashes have occurred more frequently than data would predict, so the best tack for investors might be to mentally prepare themselves for the likelihood that large outlier events will occur periodically and plan accordingly.

5) Valuation risk

The aforementioned measures of risk are all derived from investments' past performance. Valuation risk, familiar to anyone who has ever referred to P/E ratios or an "expensive" stock market, is more of a forward-looking risk. At its root, valuation risk means that you may have paid more for an investment than its fundamental worth, and that its price will eventually fall to meet its fundamental value. It can also refer to broad markets inflated by excess exuberance (think the tech bubble in 1999 or real estate in 2006). Commonly cited valuation measures for equities include price/earnings ratio (and especially the Shiller, or CAPE, ratio for the broad market), price/book, price/sales, and others, many of which can be found on the Portfolio tab of a fund's profile page on Morningstar.com.

6) Concentration risk

Concentration risk is an important risk for both individual funds and your overall portfolio. Diversification is probably the most important tool for reducing risk. A concentrated mutual fund that holds fewer securities may be prone to greater idiosyncratic risk of just a few holdings performing badly. At the same time, more-concentrated funds may possess greater potential to outperform (overdiversification presents its own kinds of risks). At the portfolio level, you should be cognizant of allocating outsize amounts to any given manager, investment style, or sector and stay on high alert for concentrated holdings in individual stocks. (Employer stock is a common culprit.)

7) Credit risk

This is the first of two specifically fixed-income related risks that I'm including. Credit risk comes into play any time you're investing in a corporate or municipal bond, or other debt instruments backed by the credit of a company or entity. Credit risk is closely related to default risk, or the risk that a company may not be able to pay back its loans. While short-term disruptions to the credit markets can lead to price declines, those tend to be temporary. Actual defaults are a far more serious risk, as they can lead to permanent loss of capital, so funds that tend to invest in lower-rated securities require heightened attention and likely should occupy a smaller role in most investors' bond portfolios.

8) Interest-rate risk

Bond prices generally move inversely to the direction of interest rates and will lose value when interest rates rise. That means bonds or funds holding longer-term bonds (most accurately measured in terms of duration) are exposed to greater interest-rate risk. If you purchase individual bonds that line up with your investment horizon, short-term interest-rate fluctuations don't really matter, but when you invest in mutual funds you will be more exposed. You should be aware of a bond fund's typical duration and how far it may deviate from its benchmark. With interest rates in a long-term downward trend over the past decade, longer duration has generally been a plus, but that won't always be the case.

9) Liquidity risk

Liquidity risk occurs when sellers have difficulty finding buyers in a thinly traded market, leading to unfavorable pricing. Some investment types, such as certain private investments, are inherently less liquid, whereas other investments may be quite liquid under normal circumstances but lose their liquidity under duress. (Liquidity freeze-ups can lead to broader market crises, which is why central banks often step in to provide liquidity to markets, as was the case during the pandemic-driven market crash earlier in 2020.) While mutual funds offer daily liquidity, managers have run into problems when less-liquid portfolio holdings have proved a mismatch for investor outflows, forcing selling (and permanent loss) at heavily discounted prices.

10) Systematic risk

Systematic risk is the risk investors bear simply for being in the market. It's unavoidable, but it can be mitigated. Beta describes an investment's sensitivity to the market (a beta of 1.0 suggests that an investment's moves will match those of the market, while a beta of 0.8 would suggest a degree of magnitude 20% lower). Factor exposures are another form of systematic risk, as they identify through regression models macroeconomic or fundamental factors that an investment may be exposed to, such as the momentum factor for equities or interest-rate sensitivity for bonds. A snapshot of an equity fund's factor profile can be found on its Portfolio tab on Morningstar.com.

11) Inflation risk

Sometimes called purchasing power risk is the risk that the growth of your investments will not keep up with inflation, or the real future costs of consumer goods. Although inflation has been suppressed in recent years, that won't be the case forever. (And inflation risk is not limited to retirees, particularly during periods when inflation spikes to unexpectedly high levels.)

12) Longevity risk

The risk that you may outlive your assets. Sequence-of-return risk is the risk that an untimely drop in the market will have an outsize effect on the future worth of your savings.

13) Correlation risk

Diversification is, of course, one of the underpinnings of Modern Portfolio Theory. Correlation can be thought of as diversification's arch-enemy: the risk that asset classes will act in concert, particularly during periods of downside volatility. For example, while U.S. Treasury bonds have been a reliable safe haven during periods of market crisis, other ostensible diversifiers, such as commodities have been far less reliable. Keep in mind that correlations can change over time, and what was once an effective diversifier may find its correlation to other asset classes increase as investors direct flows toward it.

14) Risk of not meeting goals

This is perhaps the most important and all-encompassing risk that investors should be thinking about. From a goal-based planning perspective, the risk of not meeting a given goal (whether it is a house, college savings, retirement, or a bequest) is the most consequential. All the other risks mentioned previously are, in a sense, supporting players in the bigger production of meeting your goals.

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